2024 is more likely to be an average year for markets than a double-digit winner. Find out why and what it means for your portfolio.
Investors are beginning 2024 at a precarious point. This may seem surprising, in light of recent strong performance in equity markets. To understand why, consider where things stood at the beginning of 2023: Investors were cautiously optimistic about the prospects of cooling inflation and interest-rate cuts, while still alert to the possibility of an economic recession and a dip in corporate earnings.
As we know now, the economy blew past these cautious forecasts, supported by greater-than-estimated consumer savings, more aggressive fiscal spending and looser financial conditions. The upshot: a spectacular 25% advance in the S&P 500 Index for 2023, which put the benchmark back near its record high from January 2022.
The setup today couldn’t be more different.
The market’s exuberant rally at the end of 2023 has left stocks overvalued, with investors especially emboldened by the Federal Reserve’s December indication that rate cuts are on the horizon. When investors have such lofty expectations, there’s little room for error.
Looking ahead, Morgan Stanley’s Global Investment Committee believes investors should have a more measured outlook, with 2024 more likely to be an average year for markets than another double-digit winner, given risks such as the following.
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1Excessive valuations
The S&P 500’s current forward price/earnings ratio is around 20, compared to about 17 at this time last year. Meanwhile, the “equity risk premium”—i.e., the reward an investor can expect for owning stocks over risk-free Treasuries—is at an extreme low of about 1 percentage point. While equity valuations may give investors limited insight about what kind of returns to expect in the short term, they are often accurate predictors of returns over a year or two. On that score, today’s valuation levels point to sub-par annual stock returns, with gains averaging 4% compared to the long-run average of 7%-8%.
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2Vulnerable corporate earnings
Analysts currently estimate 2024 U.S. corporate earnings of about $242 per share, which assumes companies will continue to expand their profit margins. But we think this consensus estimate is overconfident, given a likely tapering in U.S. economic growth from last year’s torrid nominal pace of about 7%, to about 4% this year. This decline would probably result in a loss of sales volume and pricing power for companies. What’s more, corporations may have already recognized the benefits of factors such as lower manufactured input costs and falling oil and raw material prices—meaning these factors may be less likely to contribute to improved margins going forward.
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3Overly optimistic rate expectations
The market continues to assume that the Fed will cut rates more quickly and steeply than it has publicly signaled: Despite the Fed’s signaled intent to cut rates three times this year, futures markets are pricing more than six. That assumes the central bank will enjoy an uninterrupted victory in taming inflation, whereas we believe inflation in labor-intensive services is still likely to persist.
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4Normalizing financial conditions
The Fed’s rapid rate hikes from March 2022 to July 2023 would typically have meant tighter financial conditions. However, thanks in part to excess consumer savings, trillions of dollars in fiscal payments and the fact that households and businesses had already locked in lower loan rates, liquidity in the financial system has been ample. That said, loose financial conditions are set to reverse in 2024, as the Fed winds down its 2023 emergency bank-lending program and as balances dwindle in its so-called “reverse repo” facility, both of which have helped to keep cash sloshing around the system.
How to Invest for 2024
Given these four risks and our forecast for more modest returns from stocks, we believe 2024 should be a time for balance—for both investors’ expectations and their portfolios.
Consider adding exposure to U.S. equities other than the market’s biggest, known as the “Magnificent 7,” by either investing in an equal-weighted version of the market-cap-weighted S&P 500 Index or by actively selecting stocks.
Maintain a preference for value over growth stocks. Financials, industrials, utilities, consumer staples and healthcare are among the Global Investment Committee’s favored sectors, especially until we see the first Fed rate cut.
